askST: What is inflation, why is it rising now and how does it affect consumers?

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SINGAPORE - Inflation refers to a general rise in the prices of goods and services without an improvement in their quality.

 

But it is important to understand the concept of inflation because prices rise and fall depending on demand and supply through the course of a year. In fact, if the economy is growing, the sum of these rises and falls in prices should result in moderate inflation.

 

The Straits Times examines this issue.

 

 

Q: What is inflation and how does it relate to consumers?

 

A: When Apple or Samsung launches a new mobile phone, it is always pricier than the previous model because of new features and more advanced technology. That would not count as inflation because the device has improved.

 

In the same vein, prices of certain food items rise during Chinese New Year before reverting to their usual levels after the festival. Such seasonal price gains are also not inflationary.

 

However, if you note household expenses on an Excel sheet every month and notice that you have paid more in the past three months for the same items you bought in the first six months of the year, then you may have caught the start of a trend of rising prices of daily-use items.

 

A modest amount of inflation - less than 2 per cent - is seen as beneficial for most economies as it encourages consumption and investment. People will buy big-ticket items such as cars or TVs if they think prices will rise if they wait for too long. Businesses will invest in equipment and land if they expect higher asset prices and they will boost hiring if they view an increase in wages.

 

But inflation starts to hurt when almost everything gets more expensive, and over time, consumers see a palpable decline in their purchasing power, that is, they need more money to buy the same goods and services.

 

When prices seem like they will stay high for a longer period or may continue to rise, governments act to protect the purchasing power of citizens and businesses.

 

Depending on the primary sources of inflation, governments can use an array of policy measures to control prices. In most countries, it is the central bank's responsibility or mandate to apply corrective measures by using its monetary policy toolkit.

 

 

Q: How is inflation calculated?

 

A: Before taking any action, central banks have to know if prices are really on an upward trajectory. That is usually done by measuring price moves on a monthly basis.

 

To systematically calculate price changes, the most widely used measure is called the Consumer Price Index (CPI) All Items. This is a fixed basket of goods and services commonly purchased by households over time.

 

To go from a long list of prices to a useful price index, you need to decide how much weight to give to all the different items. About 6,800 brands/varieties from 4,200 outlets are selected, with their weights reflecting the relative importance of each good or service in the basket.

 

So housing and utilities represent 24.8 per cent of Singapore's CPI, followed by food at 21.1 per cent and transport 17.1 per cent. The weights of other goods and services, such as education, recreation and healthcare, are in single digits.

 

There are other measures as well, such as the Singapore Manufactured Products Price Index, which monitors price changes of locally manufactured commodities, and the Domestic Supply Price Index that gauges the changes in the price level of goods manufactured locally or imported that are retained for use in the domestic economy by the Government, business or household sectors.

 

The Monetary Authority of Singapore (MAS) monitors a core inflation measure that excludes the components of accommodation and private transport, as these items tend to be significantly influenced by supply-side administrative policies and are volatile.

 

Core inflation is meant to capture the generalised and persistent price changes that are driven by underlying demand conditions. Thus, it provides useful information for monetary policy, which has the objective of ensuring price stability in the medium term.

 

 

Q: What factors usually contribute to increased inflation?

 

A: There are two primary causes of inflation - demand pull and cost push.

 

Demand-pull inflation occurs when the demand for goods and services in an economy rises more rapidly than the capacity to supply. Demand pull is the most common source of inflation and generally results from an increase in demand in response to an increase in the supply of money in an economy, usually accompanied by decline in loan rates that encourage people and businesses to increase their borrowing.

 

Cost-push inflation, considered more temporary than other sorts of inflation, occurs when the cost of production and raw material inputs, that is, the cost of supply, increases. This may occur in response to short-term supply shocks.

 

 

Q: Why is inflation rising now?

 

A: A confluence of various factors since countries started to reopen have triggered both demand-pull and cost-push inflation.

 

In response to the Covid-19 crisis, governments worldwide instituted several unprecedented policy measures to limit the economic damage from the pandemic. For instance, the United States government and its central bank - the Federal Reserve - provided up to US$2.3 trillion (S$3.1 trillion) in lending to support households, employers, financial markets, and state and local governments. This caused the supply of money in the US to swell to record highs.

 

Cost-push inflation is being powered by congested ports, shortages of containers and labour and volatile freight rates that have worsened the supply bottlenecks that started to emerge soon after Covid-19 became a pandemic last year.

 

The combined impact of increasing consumption from recovering economic activity worldwide and supply disruptions also due to severe weather events and a series of production outages has sent international market prices rising for everything, from aluminium to steel, and from oil to natural gas.

 

Businesses don't necessarily pass on all the changes in costs. They may defend their market share by choosing to absorb all or part of inflation. But if inflation is sticky, remains high for longer than anticipated, or continues to rise, they will have no choice but to raise prices.

 

 

Q: What can be done to control inflation?

 

A: Policymakers had thought that coming out of the deep economic contraction of last year would mean some demand and supply mismatches would show up in the prices of some goods and services.

 

The bet was that those mismatches would even out by around the middle of 2021. They apparently underestimated the supply constraints.

 

Now, most central banks are in a quandary. Their monetary policy tools can't fix broken supply chains, port congestion or incentivise the increased production of oil and gas, which takes time.

 

If they tighten monetary policy too quickly by raising interest rates, they might end up killing budding consumer demand.

 

If they wait for too long, inflation may get entrenched and start to eat into business revenues and tax consumption.

 

In Singapore, where most of what is consumed by households and businesses is imported, the central bank chose to make a pre-emptive move on Oct 14.

 

The MAS ended its 19-month easing stance and slightly raised the slope of its Singapore dollar nominal effective exchange rate policy band, up from 0 per cent previously.

 

That means the MAS is now seeking gradual appreciation of the Singapore dollar relative to the strength of the country's trading partners' currencies.

 

As a general rule, a strong currency makes imports cheaper. But the move will not entirely absorb the price shock.

 

The MAS expects core inflation this year to come in near the upper end of its 0 per cent to 1 per cent forecast range, and is expected to increase further to 1 per cent to 2 per cent next year.

 

Overall inflation, or CPI All Items, will come in at around 2 per cent this year, at the top end of the MAS' forecast range, and average 1.5 per cent to 2.5 per cent next year.

 

In contrast, most central banks worldwide are still hesitant to tighten their policies and believe that the bulk of inflationary pressure is transitory.

 

The International Monetary Fund warned central banks last week to be "very, very vigilant" and take early action to tighten monetary policy should price pressures prove persistent.

 

Source: The Straits Times © Singapore Press Holdings Limited. Reproduced with permission.

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